Market Overview

Keep It Cheap And Short With This Bond ETF

Keep It Cheap And Short With This Bond ETF

Amid a more sanguine outlook for U.S. interest rates this year, investors are revisiting longer-dated bonds and the corresponding exchange traded funds.

That doesn't mean the short-duration funds, such as the Schwab Short-Term U.S. Treasury ETF (NYSE:SHCO) should be ignored.

What Happened

The $5.5 billion SCHO targets the Bloomberg Barclays U.S. Treasury 1-3 Year Index and holds 85 bonds with a weighted average maturity of 1.99 years.

“Indexing Treasuries in this way is a sound approach for exposure to a specific portion of the yield curve,” said Morningstar in a recent note. “It is difficult for active managers to recoup their fees while offering comparable exposure to Treasuries on this narrow segment of the yield curve, as Treasuries are one of the most competitively priced areas of the bond market and managers have little leeway to take additional duration risk.”

Why It's Important

Credit risk typically isn't an issue with Treasury ETFs and with short-term interest rates expected to be held in check this year, SCHO, with a duration of 1.93 years, could provide a solid option for investors looking to capture some short-term income while protecting portfolios against potential equity shocks.

“Ultrasafe investments, like short-term Treasuries, are an effective way to diversify an all-stock portfolio as they tend to hold up well during periods of market distress,” said Morningstar.

What could be a near-term risk for SCHO and other fixed income ETFs is last Friday's albeit brief inversion of the yield curve, when 10-year Treasury yields fell below the yield on three-month T-bills. Yield curve behavior can impact SCHO's ability to outperform long-dated bonds.

“When the slope of the curve is gentle, the opportunity cost of investing in short-term Treasuries is low,” according to Morningstar. “But as the curve steepens, so does the potential opportunity cost. This ultrasafe portfolio provides strong downside protection because short-term Treasuries tend to act as a safe-haven asset during periods of distress.”

What's Next

SCHO charges just 0.06 percent per year, or $6 on a $10,000 investment, putting it on the more favorable end of the bond ETF spectrum in terms of costs.

The fund has a 30-day SEC of 2.45 percent. Morningstar has a Silver rating on SCHO.

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